New research suggests that institutional investors might be pouring too much love on companies with high ESG ratings, leading them to be overvalued. One result? Activists and other large block holders are building positions in companies rated poorly on environmental, social, and governance metrics, hoping to improve their standing and boost their stock prices.

Even as institutional investors are highly motivated to add companies with strong ESG scores relative to other financial measures to their portfolios, large blockholders and activist investors are less motivated by these ratings, according to a paper, called “Institutional Investors and ESG Preferences,” from the European Corporate Governance Institute, a non-profit research association.

Not only are the activists not motivated by high ratings, there is a negative relationship between the size of the ownership stake and ESG. Of course, companies underperforming on ESG scales may also be low financial performers.

There’s “a strong relationship” between institutional holdings and a company’s combined ESG ratings — institutional investors prefer to invest in companies with high-quality ESG characteristics, according to the paper’s authors, including Florencio Lopez de Silanes, a professor of finance at SKEMA Business School, and Joseph McCahery, a law professor at Tilburg University. The authors characterized institutional investors’ preference for these sustainable companies as strong, especially relative to other financial performance metrics. The authors constructed a data set for the study based on total ESG scores as well as information from Bloomberg, Sustainalytics, and Robeco.

With Too Much Love From Institutional Investors, Companies With High ESG Ratings May be Overvalued. Activists Are Taking Note. | Institutional Investor